Has the White House Changed Its Tune on the Nature of the Recession?

It may be coming around to what's really driving weak demand three years too late, but better late than never.

There's a mini-debate going on over the relationship between the housing crash and weak demand. As Cardiff Garcia of FT Alphaville recently summarized it: "This reminded us of the debate last year about whether the sluggishness in consumer spending was the result of households wanting to deleverage or was caused by the big negative wealth effect caused by the huge crash in home prices." See this from James Surowiecki on the wealth effect and the Q&A I did with Amir Sufi on deleveraging. Which is the main driver, deleveraging balance sheets or a wealth effect?

I'm more on team balance sheet. It must seem like an esoteric debate, but it has some consequences. If it's about deleveraging balance sheets, the problem is an income/debt issue. It can be solved by reducing debt through forgiveness, lower interest rates and refinancing, equity swaps, a jubilee, and many other options. The models used in these stories indicate that any kind of transfer from creditors to debtors will make the economy better off. If it's a wealth effect, forgiving debt is likely to be less important -- it's not the root of the problem. Redistribution between creditors and debtors is unlikely to have a major impact outside of marginal propensities to consume. You'd need to get housing prices back up for there to be a significant adjustment.

(When Jim Bullard made two meta-conservative cases against additional monetary and fiscal stimulus recently, he switched between these narratives. The first case was about how the collapse of the housing bubble represents a technology loss. Though he didn't specify it, people could refer to the collapse of the securitization model, the inability to use housing as collateral, and the now idle Wall Street machine --results from weak balance sheets -- as a type of technology that has been destroyed. I don't think that's a particularly useful way to look at it. The second argument was pure wealth effect: we feel poorer, and the only solution is to beg policymakers to "please reinflate the bubble." That's a pretty significant change in the underlying theory.)

Garcia noted that the Federal Reserve looks like it is considering joining team balance sheet. It discussed three studies at its most recent meeting, all credit and balance sheet related. One of the studies "used data on borrowing, debt repayments, and other credit factors for individual borrowers; this study found that movements in leverage -- resulting from voluntary loan repayments and from loan charge-offs -- have had a substantial effect on the cash flow of many households over time, and thus presumably on their spending." I'd really like to see that study!

The standard approach in economics has been to assume that households consume about the same fraction of the increase in their wealth each year, regardless of its source... The severity of losses experienced during the recession that began in December of 2007 in both national output and in labor markets makes these estimates appear too small...

A growing economics literature highlights the importance of household debt balances in influencing the severity of economic slumps... A series of empirical papers attempts to quantify the effect of such deleveraging on consumption (Mian and Sufi 2010; Mian, Rao, and Sufi 2011). These papers broadly suggest that the levered nature of household housing assets amplified the effect of pure wealth losses from the crash in housing prices.

The report even includes this iconic chart of team balance-sheet:

When Noam Scheiber wrote about how the administration viewed the economy in late 2010, he explicitly contrasted its wonks' opinions with that of the balance sheet recession theorist Richard Koo. So is this a revolution within the administration? Is this why it is now pushing for writedowns and refinancing, after having left housing on the side for the past three years? Let's hope so, since I consider being three years late to the party better than never showing up.